Beware US index funds

By Neville Bennett

Friday 8th November 2002

In the last few years index funds have been the darling of many financial planners. The simple message is you will get rich as the market grows Dow-Jones or S&P500 at rocket-like speed.

Should any reader still be in index funds, and a lot of superannuation funds are, they might consider the probable accounting changes in the US. My guess is that US index funds are dog tucker.

The proposed changes deliver a double whammy. It is proposed that businesses must register the true cost of their share option programme and there must be proper accounting for pension liabilities. These are going to be a terrific drag on corporate net earnings, and in particular are going to transform P/E ratios.

S&P has already started to report earnings using a new standard. It has introduced "core-earnings" as a replacement for "as reported" earnings. The new concept includes stock-option expenses: pension costs, gains and loses from hedging operations.

The firm stresses that investors need to pay close attention to the effect of pension accounting in evaluating a company's financial performance. As-reported earnings per share in the S&P500 were $26.74 but under the core earnings treatment the yield falls to $18.38.

The finance industry has not yet caught up with this change. Many brokers insist that average earnings per share are $44.93 a share. This gives an optimistic P/E ratio of 17:1. I calculate that on the core earnings basis, the P/E ratio is not 17:1 but 48:1.

The leading equities are thus still much overvalued. Not many people can wait 48 years for the return of the capital. This will exert downside pressure on many stocks. At a minimum, it mitigates against a strong rally, as historically, no bull run started from a high valuation.

Yet optimism persists. Professor Jeremy Siegel, of Wharton Business School, claims the great technology bubble has truly been burst. Even though he knows about S&P policy, he persists with the opinion that "over the next 12 months, reported earnings are expected to rise using conservative methodology to $37.79."

Some time ago I wrote about how stock options played an important role in financing dotcoms. They assisted mergers and are a large part of remuneration. Frequently the options were left off the balance sheet.

But they are an expense and S&P is getting tough. In its latest report, it calculates that the average share should carry $5.21 in additional expenses for stock-option grant expenses.

If stock options are properly expensed, they do reduce earnings. One study of the top 15 companies in the Nasdaq compared their declared earnings of $15 billion with the reality check of unrecorded stock-option expenses of $12.5 billion. The study concluded that the P/E of the top 15 Nasdaq stocks collectively was over 1000. Moreover, if Microsoft were removed from consideration, the remaining 14 companies would aggregate net negative earnings of $3.5 billion.

The Nasdaq reminds me of many Japanese corporations in the 1980s. They went hell for leather by growth and condescendingly said the pursuit of profits was archaic. They would grow market share at all costs, including a little "financial engineering."

Many of those corporations now have bad debts and are kept in limbo by over-cautious banks. The options boom was the US' financial engineering in the 1990s.

The rationale of the market share philosophy is that opponents will be blown away. My impression is that it has not worked for many corporations. Competitors keep rising. Technology shifts. Competition is squeezing all margins.

Many S&P500 household names are in trouble due to their pension liabilities. Three hundred and sixty of the 500 have pension plans and the liability is estimated at $300 billion. According to Barron's, 240 companies had under-funded plans at the end of 2001.

Pensions have been listed as assets on many balance sheets, even when there were deficits.

The old system worked something like this. A corporation asks a consultant the projected value of its fund. The consultant errs on the generous side and says there will be tremendous growth. The corporation books some of this as a profit.

In 2001, S&P500 companies booked profits of $104 billion on their pension funds. Oddly enough, their funds actually declined by $90 billion.

Under the present law there is no great harm in factoring in a growth rate of 10%. But that is changing now and investors should be aware of a momentous change. S&P's core earnings specifically exclude pension gains and it is their practice to look critically at pension funds. The impact is tremendous.

General Motors' scheme has been judged as underfunded by $29 billion. That is 24 times their earnings of $1.2 billion in 2001. It is unlikely that GM will put $30 billion into the fund next year. But it will not be permitted to massage the figures as S&P has downgraded GM and has put Ford on credit-watch.

Other companies are in a more desperate fix. For example, AMR, the parent of American Airlines and Goodyear Tyres, has a market capitalisation of $700 million but has under-funded pension liabilities of much greater magnitude. It may be forced to add $1 billion to the fund this year. Northrop is unable to talk about profits in 2003 until it has sorted out its pension provisions.

At current levels, the earnings of 82 companies in the 500 would have halved if there were no phantom pension profits.

The situation will deteriorate even further if the market falls. Pensions will then be more under funded.

Given S&P's robust attitude to pension and option accounting treatments, it appears that many companies have relied for too long on "as reported" earnings. Their earnings are distinctly over-stated, and in consequence, P/E ratio's need substantial revision.

Few investors are aware of this momentous change. But beware. S&P reports, "If 2002 was the year of options, 2003 will be the year of pensions." This makes a commitment to index funds very perilous.

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